Suba at WealthInformatics left a comment on my previous post about my asset allocation. Which was very awesome of her. Unfortunately, she asked so many good questions that just one comment reply couldn’t hold all the answers. And the comment reply filled up and filled up until it hemorrhaged out into a blog post. Thus, we have the this blog’s first FAQ. And why “part 1″? Because I’m sure that more parts will follow as soon as more people start asking me questions.

Suba’s comments are in bold. My replies are in regular text. And occasionally italics.

I have no idea what put options are (Note to self : look them up!)

You should totally look into put options, they can be great investment tools. I’m currently working on an entire options primer series, which will be posted here one day. Hopefully, it will be at least mildly informative.

I use put options in two ways:

First, in place of a limit order. Getting paid to wait is better than waiting for free. This is the purpose of the NLY put in my portfolio. Unless that stock shoots way up in price over the next few weeks, I’ll have used the put to purchase it for the exact same price (strike – premium) that I would have bought it for anyway. And if the stock does shoot up, then I get to keep my $164 as a “thanks for playing” consolation prize. I’m a bit worried about how QE-infinity will affect NLY’s business model, but… 1) That risk is part of the price paid for chasing yields. 2) If NLY’s dividend drops to the lowest dividend it’s ever paid, I’ll still be pulling in >10% yield, which is exactly what I’m looking for in the high yield portfolio.

Second, as a bet that the stock will go up in price. If the stock goes above the strike price of the put, I get to keep the option premium (what I sold the put for) and when the put expires or is closed all my secured cash is freed up. Because this is a bet, I only bet against stocks that I would have bought already. This is the purpose of the NSC and INTC puts. I don’t sell these style puts unless I can pull 10% annualized returns.

I checked out your portfolio, you have a well diverse portfolio with companies from a lot of sectors. Is this all your investment or a taxable account?

I’m still working on my diversification. Because I buy stocks as I get money, and for the last few years I have been making 1/3 less than I’m making now, it’s been a slow road. But that’s fine.

I do invest 6% of my gross income in my 401(k). I get a 100% match on that money and have a policy of not leaving free money on the table. My 401(k) investments are in a very boring index fund, with thankfully low fees. I may write about this in the future if I ever do a net worth update.

What I show on the blog is all in taxable accounts.

I’m targeting financial independence at age 45. Assuming no major life disruptions between now and then, this should be achievable with a >50% savings rate. A bold assumption, I realize. In order to do that, I need my money working for me immediately. Not locked away until I’m 59&1/2. One of my main reasons for wanting financial independence is insurance against layoffs and materially adverse changes at work (i.e. replacing my boss with a complete douchebag). Money locked away until I’m nearly 60 isn’t going to be very useful for that purpose.

The reason I ask is I don’t see any mutual funds, may be you prefer stocks instead?

Either mutual funds or stocks can be used to accomplish the goal of financial independence. Your personality and interest-level will help guide your decision.

For mutual funds, your investment strategy is usually to accumulate a ginormous (side note: when did “ginormous” become an actual word?) pile of cash, then shave 3%-4% of it off every year. This constitutes the safe withdrawal rate. Safe, is of course, a relative term. The smaller your withdrawal rate, the safer your savings. So how much do you need to save? For a simple starting point I should shoot for your yearly expenses multiplied by a number between 25 (4% withdrawal rate) and 33.3 (3% withdrawal rate).

For dividend growth stocks, you still have to save a lot of money. But the target is different. Once the yearly income from your portfolio matches your expenses, you’ve hit the the crossover point. Crack open the Champagne. Welcome to financial independence land.

Psychologically, using my expenses as a target is much more appealing, then targeting a quantity of money so large I can barely imagine it.

I really hate the fees associated with most mutual funds.

I don’t mind putting in the extra effort to build my portfolio. If you’re not interested in investing, go for mutual funds. Maybe you’re better at being super frugal or entrepreneurial – both of which can be used to boost your savings rate.

Having my expenses as a target also drives me not to waste money. The lower I keep my expenses, the faster I’m at financial independence. I realize it’s actually the same whether you’re using expenses or a giant pile of money. But psychologically, expenses work better for me.

I dislike the idea of shaving off parts of my principal in order to fund my living expenses. Just seems like knocking down the walls of my house for firewood.

Also I heard dividend stocks are great for income but they don’t grow as much as the stocks that doesn’t pay any dividends. Is that correct?

This is a half truth.

Consider the stocks in my dividend growth portfolio. Most of those are solid blue chip stocks. The kind you see on the major indexes like the S&P500. The beta’s for most of those stocks are around 1, which means that they’re basically tracking the market. So you’ll be getting as good of capital growth as a standard index fund.

Now look at the stocks in my high yield growth section. Those are mostly MLPs, BDCs, REITs, and other very high yielding stocks. I expect much less growth from these stocks. But in total I’m getting around a 10% yield from them.

I started this strategy back before I got a real job and wanted to find ways to juice up my available cash for dividend growth investing. I’m not as comfortable with it as I am with more traditional dividend growth investing and that is why these stocks are limited to 10% of my holdings.

So in conclusion, the amount of growth you can expect depends largely on which dividend paying stock you pick.

So you are going for income rather than massive capital growth?

If by massive capital growth you mean chasing IPOs and hot tech stocks hoping to land a 50-bagger, then no. I don’t understand enough about those businesses to be able to make good decisions about them. A lot of their growth is driven by pure speculation. There is no reason on Earth why company that sells overpriced electronics to yuppies should ever be worth more than a company that supplies the very life blood of modern civilization.

Now, if you’re talking about being able to do at least as good as the S&P500, then yes. At present I’m doing slight;y better than the S&P500 in terms of capital gains. I’m going to write a post about this sometime in the future. I’ll even include a graph!

Readers: What are your opinions? Are dividend stocks good for capital gains, or only useful for income?

8 Responses to "The Big Blog FAQ Part 1"

Interesting post. My question is what your thoughts are about index funds through a low cost provider such as Vangaurd which has ridiculously low fees, especially if you buy the Admiral Shares funds (minimum $10K to open). Your thoughts?

Thanks for stopping by. Index funds can totally work. You can easily achieve financial independence through something like Vangaurd’s Admiral Share. The crux of early financial independence is savings rate. Once you’ve got that down, everything else is a different flavor of investing.

I like dividend growth investing because I like to be involved in my investments and because I get motivated by watching my dividend income go up steadily with each purchase. If trying to build up a giant pile of money (index investing) so that you can shave off a few percent per year motivates you, then go for it.

Oh trust me, I dig watching the dividends pile up too. I’m actually doing a bit of both, index fund investing through Vangaurd and Fidelity (old 401(k)’s that have been consolidated into IRA’s) as well as buying individual stocks through my Fidelity Brokerage account. I just find I don’t have the time to do proper research and like the idea of index funds. I completely agree that savings rate is key. At present, I’m saving approximately 30% of my gross in my company 401(k) and other vehicles (index funds, series I savings bonds, Ally Bank for emergency fund and my brokerage). Actually, it’s more than 30%. I don’t count my short term savings for things like home improvements, new car fund, vacation fund, taxes and insurance fund (again, through Ally Bank). Since these funds will be accessed as needed (except for the car fund which will likely continue unused for at least 5 years), I just don’t count that as my FI pile of money. I do pay more on my mortgage than the monthly payment (refinanced last summer for 10 years at 2.625%). Payment is $969. I pay $1025 which will have me paid off in about 8 years from now. Some blogs I’ve read count the overage as savings too but I’ve not included that into my calculations. If I included all of the above, my savings rate would be just noth of 44%. Overall, I think I’m on the right track. I’ll tweak things as soon as I see what the impact of the 2% payroll tax going away is. Assuming an increase in salary, that will cause more tweaking as well.

Saving 30% of your gross is pretty good. I make my savings rate calculation off of my net income since I’m planning on becoming financially independent way before I retire.

I wouldn’t count short term savings either, especially if they are already earmarked to be spent later. I do count my emergency fund. Once I get it up to a good level, I’ll shift those funds into my investment account.

Once you get your mortgage paid off, your savings rate will skyrocket and your expenses will drop. That will make a nice boost in how quick you can achieve financial independence.

It sounds like you’re making good progress. It’s all a balancing act. Income, needs, and wants vs how long you are willing to wait to achieve financial independence. The best answer is the one that you can stay on target with. There’s no point to having a 70% savings rate if you get tired of the lifestyle in a year and give up.

I always find these discussions interesting. Clearly there is no right answer, circumstances are different for everybody.

I very much enjoy dividend & income investing. Here’s why:

1) Dividends are disconnected from market prices. I know when the market tanks my favorite companies such as KO, PG, and MCD are still going to make payments to shareholders (and likely even increase them). The price of the stock does not affect my income stream! This is huge psychologically. One of biggest mistakes investors make is panic selling on irrational fear. By focusing on the income stream I no longer really care what my portfolio is worth or if it beats the S&P 500. When my portfolio hit $100,000 a few months back, there was no celebratory post on my blog. When my annual income hit $3600 there was a post about that however! It’s a whole new paradigm and helps me to stay the course and not panic sell.

2) I do not like the idea of selling assets to support retirement. If I have to sell assets, am I really ready to retire? I think not! When my dividends/bond income + pension are greater than my expenses I know I’m good.

3) It suits my personality and I love researching great companies. It’s a joy to look at my grocery receipt and notice almost half the products I just bought are made by the companies I own. I love buying gas at a Chevron station knowing part of the profits will be returned to me in a few months as a dividend. The list goes on as my portfolio grows. It’s very motivating.

Great points. I agree wholeheartedly. Especially with your comment about how dividend income streams don’t dip when the market tanks. There are exceptions, like the financial sector in 2008. But losing 10% of income is easier to soak than losing 40% of your principal at a 4% withdrawal rate.

First to give a little background, I never really understood all the nuances of stock market. Most of our investing is therefore in index funds. Our stock market investing is limited to the amount that we could lose and not lose our entire retirement. That is what mainly inspired my question on mutual funds.

And my question about massive growth was based on my assumption that dividend stocks won’t grow as fast as the others. I was not talking about IPOs or private investments. Again, I should think more broadly as our dividend portfolio serves the single purpose of providing us with some income (even when the market tanks). And so many other dividend investment bloggers emphasize on the income part than the growth part so I assumed a lot of people had it for income purposes.

Thanks a lot for explaining! Great food for thought! I am still learning on investing in individual stocks. We only have a small portfolio of dividend stocks (Intel, which I see you have discussed today, JNJ, PG and WAG). Hopefully I can expand my knowledge in that area.

I don’t understand all the nuances of the stock market either. But the nice thing about investing is that by focusing on buy and hold investing in dividend growth stocks, I can focus on just those aspects of investing related to choosing stocks based on strong fundamentals. That’s a much smaller stack of nuances to understand. The hard part is putting in the time.